A Look Back at the Lending Club and Prosper Quiet Periods

This is a question I get regularly: what does this “Quiet Period” thing mean? When discussing the history of Lending Club and Prosper I have often mentioned this mysteriously named Quiet Period but I have never fully explained what this meant. So today we will take a look back and explain what happened as I understand it.

When both companies launched, their interpretations of the financial laws were that they were functioning in a similar way to a banking intermediary. Therefore they should be regulated in a similar way to a bank. But the government thought differently. They thought the investor notes should be treated as securities and therefore they should be regulated by the Securities and Exchange Commission (SEC).

The Lending Club Quiet Period

In early 2008 Lending Club saw the writing on the wall and decided to shut down voluntarily and go through the registration process with the SEC. They entered a quiet period by posting this message on their blog on April 7, 2008. Here is an excerpt:

Lending Club has started a process to register, with the appropriate securities authorities, promissory notes that may be offered and sold to lenders through our site in the future. Until we complete the registration process, we will not accept new lender registrations or allow new commitments from existing lenders. We will continue to service all previously funded loans during this period, and lenders will be able to access their accounts, monitor their portfolios, and withdraw available funds without changes.

Lending Club was closed to new investors and existing investors could no longer fund new loans. However, Lending Club continued the borrower side of their business and funded borrower loans with their own money.

The Prosper Quiet Period

Prosper initially disagreed with Lending Club’s interpretation of the law and continued operations. But they soon changed their mind. In the same week that Lending Club emerged from their quiet period Prosper entered their own one with a very similar announcement on their blog:

Prosper has started a process to register, with the appropriate securities authorities, promissory notes that may be offered and sold to lenders through our site in the future.

Until we complete the registration process, we will not accept new lender registrations or allow new commitments from existing lenders. If you’re an existing lender, your current lender agreements will be unaffected; your existing loans will continue to be serviced; you’ll be able to track and monitor your loans; and you’ll be able to withdraw funds from your Prosper account.

The biggest difference between the Prosper quiet period and the Lending Club quiet period was that at Prosper they closed down the borrower side of the business as well as the investor side. No new loans were issued during the Prosper quiet period.

Why was it called a Quiet Period?

It was called a quiet period because during the process of SEC registration the management of both companies were forbidden from talking publicly about their company in any way. Lending Club even took it to an extreme when they won a Webby Award during their quiet period. They accepted the award with a banner that read: “Can’t say anything. Quiet Period”.

How Long Did These Quiet Periods Last?

Lending Club was in a quiet period from April 7, 2008 until October 14, 2008. Prosper was in a quiet period from October 15, 2008 until July 13, 2009. It should also be noted Prosper received a cease and desist letter from the SEC on November 24, 2008. But by then this was somewhat of a moot point since they were already ceasing and desisting by being in a quiet period.

What was Different After the Quiet Period?

The biggest change after the quiet period was that a secondary market was established at both Lending Club and Prosper. The notes were now considered securities so they could be bought and sold in an open market. Both companies chose Foliofn to run their secondary market and when investors opened a trading account they could now sell their notes on the open market.

The other change was that instead of being available in almost every state before the quiet period Lending Club and Prosper were now only available in around half the states. Existing investors in the disallowed states could keep their accounts but were forbidden from investing in new loans. On Lending Club some investors in these additional states were able to buy and sell loans on the trading platform but could not invest in new loans.

At Prosper they also used their quiet period to retool their underwriting strategy. In Prosper 1.0 (the time before the quiet period) sub prime borrowers with a credit score under 600 could obtain a loan on Prosper. In Prosper 2.0 the minimum credit score needed to obtain a loan increased to 640. Along with that requirement came a much more rigorous underwriting system that included a Prosper Rating and a Prosper Score.

P2P Lending Since the Quiet Periods

It is easy to forget that during the quiet period many people thought that neither Lending Club or Prosper would survive. Several bloggers wroteobituaries for Lending Club when they entered their quiet period and people questioned whether Prosper would survive as well.

At Lending Club it is now more than three years since they emerged from their quiet period and at Prosper it is about two and a half years. Both companies have grown tremendously since their early days and the quiet period is slowly receding into history.

The big change that the SEC registration requirement has had it that competition has been very much stifled. There is now a large barrier to entry for new companies looking to compete with Lending Club and Prosper. Both companies had the resources to weather the storm of their quiet periods but new companies looking to compete directly must go through SEC registration. This is an expensive process that requires an investment of more than $1 million in legal fees alone.

So we are left with an oligopoly of sorts in p2p lending in this country. And that doesn’t look like changing any time soon.

Although the expression “anytime soon” is open to interpretation, I don’t think $1 million or even $50 million is standing in the way of a competitor opening shop. Look at how much has already been dumped down the Prosper money pit…………with no end in sight, & certainly no profit in sight.

The reason no one has joined the fray yet is actually quite simple. It’s because the ability of the p2p business model to even smell a profit under conditions other than the current lowest deposit interest rates in modern history, is still VERY much in doubt.

This is America so I have no doubt that p2p will be able to attract more & more borrowers as time goes on. The problem will be attracting investors when interest rates eventually rise. I’ve said it before & will say it again,……… For individual investors, I believe that p2p will encounter increasing investor resistance with as low as a WIDELY available 4% intermediate term (3-5yr) CD, even though I hate to make the direct comparison between cds & p2p. At 6%, heavy resistance. At 8% this business model becomes untenable……………unless they can substantially increase interest rates to borrowers & pass that on to investors. This is why no one else has entered the game. It;s not about the entry fee.

Or it could be next week. Look at how long the Italian 10 year took to go from 4% to 7%.
Look at how quickly the French Bonds jumped after there banks were down graded and the country it self was put on a negative rate outlook.
Our 10 year can go from ~2% to ~4% just like that as well.

@Dan All investments will face challenges if/when interest rates go up. High dividen stocks have been a haven for those looking for income. Once 5 year CD or T-bills are in th 4-5% range this investor class will leave high dividen equities.

Same thing with LC. Earn 8% with a risk or 4% with no risk? A fair number of investors will chose the 4%.

@Sun, With the financial world falling apart in 2008 one could make that assumption but external financial conditions had little to do with the quiet periods.

@Dan, Yes that is a fair point. If both Lending Club and Prosper were profitable right now then I imagine there would be a lot more interest from the venture capital community. Although without the $1 million+ entry fee I know we would have a dozen or more players right now. So, I don’t think we can ignore that fact.

You bring up a good point about increasing interest rates. I don’t think 6% or even 8% interest rates make p2p lending untenable, but it will change the dynamic. Obviously no one is going to invest in a loan that pays 10% when they can get 8% on an FDIC insured deposit. There will always need to be a risk premium for p2p lending. So, on Lending Club the A,B & C grade loans and on Prosper the AA, A and B grade loans just go away or are repriced dramatically higher. But even if they go away that will still leave plenty of loans for investors.

Anyway, as @Lou says this is all hypothetical and we are likely several years away from interest rates going up significantly.

Peter……..sure, but the point could also be made that the last thing this unproven industry needs right now is a bunch of underfunded companies who figured they’d give this a shot because there’s a low entry fee. Can we say Loanio?

All………..I’m with Charlie H. on this one. The Fed can only control interest rates to a point & even then, it doesn’t do so in a vacuum. Besides, the Fed is mostly just reacting. Most people have really short memories & can barely remember last weekend. Let’s refresh that memory with these sharp & quick movements in our historical 3 month CD rates:
Jan 1975………..10%
Jan 1976…………6.2%
Jan 1979…………8.5%
Jan. 1980……….11.5%
Jan. 1981………..13.5%

There are many other examples. Who knows where CD interest rates will be a year from now. Unlike Peter I don’t have high confidence that p2p has a plan B if it rises substantially.

@Charlie, I don’t think there will be any material impact on p2p lending until 10 year treasuries head over 5%. Right now you can’t even get 2%. It could change rapidly, of course, but with all the economic uncertainty in the world it would be a brave person who predicts a sharp increase in U.S. interest rates in the next 12 months.

@Dan, It is a double edged sword. On the one hand an open and vibrant market usually leads to great innovation and a better deal for consumers. Having a high barrier to entry leads to less innovation but hopefully more stable companies. I just wonder how much bigger and better Lending Club and Prosper would have been if they didn’t have to spend millions of dollars on legal fees that adds no value whatsoever to the borrower or investor.

Ok then, who is willing to make a prediction on where interest rates will be at the end of 2012? I will go out on a limb and say 10-year treasuries will be 2.5% – 2.75% on December 31, 2012.

Maybe it’s just me, but I think that most people who fear the interest rates on CD’s and savings accounts are forgetting one important aspect: If banks are paying higher interest rates, they are also charging higher interest rates. You can’t assume that if the returns on p2p lending will remain around the 10% or so that Prosper is claiming, or the 8 – 10% Lendstats is showing. Both Prosper and Lending Club will adjust the rates they charge borrowers to keep in line with the overall market and demand for loans and for Notes.

The only real issue I see is the demand for all loans falling. If that happens, then the ability for Prosper and Lending Club to make a profit on the fees they charge now will be much more difficult. They may end up having to increase the fees they charge or end up burning through a whole lot more cash just to keep operating.

@Roy, Very true. If 10-year Treasuries are at 6% then bank mortgages will start at around 8% and HELOC’s will be well above 10%. Then I expect Lending Club’s rates to start at around 10% as well.

@Charlie, I think Lending Club and Prosper will have no problem attracting investors as long as they can maintain a 5% or more premium over FDIC insured investments. Whether they can do that in a high interest rate environment remains to be seen.

@Dan, I am not sure what the leverage limits are on banks these days. I have always thought it curious that banks can create money from thin air with leverage and lend it out to borrowers.

Just typed out a very long response about the “weirdness” of fractional reserve banking, but the submit butten crashed.

What if Lending club was a bank?
What if Lending club issued “CD” to investors?
What if Lending club funded their own loans via this investor capital?
The amount of capital needed would be much lower due to fractional reserve banking.

Indeed since every $1000 of P2P lending come from $1000 of investor capital, no new money is created by these loans.

In traditional banking a $1000 loan comes from $111.11 deposit and $888.89 created out of thin air. (assuming a 10% fractional reserve requirement)

This 888.89 of money to the economy.

Net Net a P2P loan takes money out of the system. (Money is not created that other wise would have been)

I wonder if anyone has every thought about the MACRO economic effects of P2P lending.

I did a blog post on this once as many were looking at P2P lending as a solution to a broken banking system.

P2P is a great democratisation of finance and a real move forward, but as you point out, we rely on the banks for the creation of money.

I am from the Uk and we do not even have a reserve, banks create as much money as people will borrow.

But if people move money from banks to P2P it does take money out of the system as it is not multiplied and leveraged up.

If this happened on mass it would cause a big recession and hence can only stay as a niche until we seriously rethink the bank ponzi scheme and find an alternative way to create money that does not revolve arraign banks creating money as credit. But the niche is big enough for a few decent businesses before the banks try and acquire them in a few years time.

Hope they dont sell out, but they are backed by VC’s looking for their exit, so very likely.

Simon………..I can only speculate that the UK & Europe may not call it a reserve requirement, but they must have something similar. Otherwise we should start a bank in the UK, take in deposits of a million pounds, then proceed to lend out 1000 times that number at below market rates to anyone. In no time we would be the largest bank in Britain. Shortly thereafter the entire banking system would implode. Obviously such a scenario could not happen because individual banks cannot just, as you say, “create as much money as people will borrow”. There must be a capital ratio in place that limits the amount each bank can lend as a ratio to capital. Therefore there must be some “central bank” type of institution that determines what that requirement is. That central bank is the only one who can create money out of thin air………..

Perhaps I misunderstand you, but it sounded like you were saying that each bank in the UK can lend at any multiple to their capital as they see fit , in total disregard to their deposits & capital. Surely this can’t be the case?

If you make the same assumptions as you would for a bank in a fractional reserve system, then the money we lend out will ultimately end up in another bank…to be lent out again. So really, our account at Prosper or LC is really just The Bank of (enter account name here, e.g. worth-blanket2). Welcome to the ponzi scheme! When you deposit funds into your account, you are making the initial deposit. Worse yet, you don’t have to follow the fractional reserve system so you can lend out the entire amount of deposits into your own personal bank. So assuming a straight transfer of assets from your bank or credit union into your p2p lending account, p2p lending grows the ponzi scheme rather than shrinks it.

You always have very insightful comments, but I am a little confused. Are you agreeing with Simon?

If I am understanding you correctly are you speculating banks are using P2P lending to loan money that does not exist (because of the fractional reserve banking system)? In essence the are leveraging money on the P2P platform to amplify gains – or potentially losses.

Interesting comments everyone. Thanks for the clarification Charlie, I knew there had to be some reserve requirements.

With a total money supply of somewhere around $10 trillion p2p lending has a long way to go before it has any impact whatsoever on the macro economy. Lending Club and Prosper could each be doing $10 billion in new loans a month and the effect would still be negligible. And by then I expect the lending model will look very different.

@Michael, I am arguing that p2p lending increases the money supply, which I believe is the opposite viewpoint to everyone else.

My view is that if one were to deposit $1,000 into a bank that (in a 10% reserve requirement banking environment) the bank would then lend out only $900. Since p2p lending is not subject to that reserve requirement, if I were to deposit $1,000 in my p2p lending account (instead of depositing it in a bank) I could lend out the entire $1,000.

So, instead of Bank B getting a $900 deposit after Bank A makes the first loan, Bank B would be getting a $1,000 deposit after the first loan from a p2p platform. Assuming all the money stays within the banking system on subsequent loans, then the p2p money lent out “creates” more money and has an inflationary effect.

@Charlie, The idea behind a fractional reserve system (assuming 10% rr) is that if I were to deposit $1,000, the bank would lend out only $900. Then that $900 would make it back into the same bank or another bank, which could then loan out $810 or that $900. Then that $810 would make it into the same bank or another bank, which could then loan out $729 of that $810. And the process repeats until there is in essence $9,000 in loans from that original $1,000. What I am saying is that the $1,000 I deposit into my p2p has no reserve requirement so I can lend out the entire $1,000. Then that $1,000 will make its way into a bank which can lend out $900 of that $1,000. That $900 will then make its way into the same bank or a different bank, which can lend out $810 of that $900. And the process repeats.

So, in essence a $1,000 deposit is actually turned into $10,000 in loans if started with a p2p loan rather than $9,000 if it were deposited into a bank. It is an accounting “trick” based on assets and liabilities rather than actually creating $8,000 or $9,000 (i.e. no new money is physically created).

I agree with your two statements, but I’m not sure what your point is. My point is that depositing money in a bank will increase M1 at a slower rate than depositing money into one’s p2p lending account because banks are governed on what percentage of their deposits they are allowed to loan out while we are not. Does that make sense?

all this talk of fractional reserves and creating money out of thin air . . .
to me that sounds bad.
i don’t mind if my piddly lending club investments do not get leveraged into more spontaneous money.
creating money out of thin air sounds like inflation. it certainly makes money in general worth a little bit less.
if we take the extreme usury out of the credit system, then how is that bad for the economy? it won’t light up the vegas style jackpots some people hit and therefore it is certainly more boring, but a more modest financial landscape sounds pretty awesome right about now.

@Mabel, I am not an economist or expert on money supply so I can’t comment on the ramifications of taking leverage out of the system. We have had bank leverage for many decades and the banking system did fine until this leverage started to get out of control last decade.

Clearly this is a confusing topic which tempts me to wade in with my own explanation. First of all, I agree completely with Roy S., there is no basic difference in the ability of Peer-to-Peer lending to create money out of thin air. For instance, if I want to add to the money supply I just need to use my good credit score to borrow $10k from LC at low interest rates and then lend that $10k back to LC borrowers at slightly higher interest rates. Those borrowers then do exactly the same thing and lend that $10k back to other LC borrowers at higher rates still. If this repeats 10 times then $100k of new money has been created, along with $100k of new debt. In fact, because there is no reserve requirement, this process can repeat infinitely, so my $10k initial loan could theoretically go on to create millions of dollars of new positive balances. The important thing to realize here is that this is exactly the same process as banks use and each LC participant in my example would be fulfilling the same function that traditional banks do today.

Secondly, people shouldn’t fear leverage because it seems to be mystically creating money. In fact, anyone that has a mortgage and a bank account is leveraged. And there are good reasons people pay extra interest in order to maintain an emergency fund in lieu of paying down their mortgage principle further. The cost to them is the interest rate spread between the fund and the mortgage balance but the benefit is additional safety. An alternative strategy is to invest in risky LC loans instead of paying down mortgage principle on hopes that returns will be greater than the fixed rate on the mortgage. Both situations are leverage, the first decreases risk which is paid for in interest rate spread, the second arguably increases risk and likely return.

Hi Brandon, Thanks for chiming in and giving us some perspective on leverage. It is still not something I fully understand because I have had different people explain it to me in different ways. But your explanation helps.

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